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 / Winter 2003 / Issue 33(originally published by Booz & Company)


The Big, the Bad, and the Beautiful

As the early leader in creating an auction community, eBay built a network unmatchable by others. The site claims to have had 28 million active customers in 2002, and it offers about 16 million listings in its 27,000 categories on a typical day. UBid Inc., the second largest auction site, claims 3 million registered users bidding on its rotating stock of 12,000 branded products in 16 categories.

Even though uBid compares itself to eBay, its inherent business model offers less of a network effect. Since eBay primarily auctions used products, its customers tend to be both buyers and sellers. Competitor uBid auctions new branded products from a small base of dedicated sellers. This means the more customer-bidders there are joining the network, the higher the realized price will be on the network. This benefits the small population of sellers, but harms the disproportionately larger community of buyers.

In other words, sometimes a network, however large, produces little value. Many dot-coms focused on growth in customers as a key strategic tenet under the false assumption that size always translates into competitive advantage from scale economies and network effects. Such was the expectation of the ill-fated “last-mile delivery” companies Webvan, Kozmo, and UrbanFetch, but in reality their costs were largely variable and their customers didn’t get incremental value from an increase in the customer base. (See “The Last Mile to Nowhere: Flaws & Fallacies in Internet Home-Delivery Schemes,” by Tim Laseter et al., s+b, Third Quarter 2000.) Here size added little advantage, and ill-advised pursuit of rapid growth led to their demise.

Economies of Scope
The third theory supporting the size argument, economies of scope, concerns the benefits achieved by offering more than one product or service through the same organization. Economies of scope can affect both supply and demand.

General Electric captures demand-side benefits through its ability to bundle services from its financing unit with products from manufacturing units. For example, GE has long allowed its customers to finance the multimillion-dollar purchase of its jet engines via a leasing arrangement from GE Finance. More recently, GE has pursued a service strategy of selling “power by the hour” so that an airline doesn’t buy a specific engine. Instead, a customer pays for access to a rotating stock of engines serviced and maintained by GE. On the supply side, GE Appliances combines with GE Motors and GE Aircraft Engines to purchase sheet steel in larger quantities for lower prices.

The most powerful economy of scope at General Electric, however, is probably the least tangible: Its vaunted management development system. (See “GE's Next Workout,” by Art Kleiner, s+b, Winter 2003.) The company can provide a breadth of experiences to its managers, who ultimately transfer best practices across disparate divisions. For example, Six Sigma, the analytical improvement process, was viewed largely as a tool for high-volume manufacturing operations until GE proved it could be applied across its wide range of businesses, including broadcast network NBC and finance arm GE Credit.

Cisco Systems offers a New Economy example of a strategy based on economies of scope. Originally a focused producer of Internet routers, Cisco launched what ultimately became a massive expansion of scope with its acquisition of Crescendo Communications in September 1993. From this initial expansion from routers to switches, Cisco made 39 additional acquisitions through 1999 and now boasts a full line of network equipment as varied as modems, wireless local area network equipment, and optical switches. Cisco thereby captured economies of scope by putting more products through the same organization. It loaded the new products into the plants of its existing contract manufacturers, and its sales organization could then offer complete solutions to its partner customers. These economies of scope helped Cisco build its dominant position as a supplier of the infrastructure of the Internet.

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